Fiscal Consolidation of state governments in India- Explained Pointwise

The fiscal consolidation of state governments in India has become a matter of vigorous debate between the Union and the State Governments. Recently, Government of Kerala has approached the Supreme Court for increasing the borrowing limits of the state to bridge their deficit. The Union government contends that the borrowing limit of the states must be restricted to 3% of the State’s Gross State Domestic Product (GSDP). This restriction on borrowing limit has created a tussle between the state of Kerala and the Union government.

What is Fiscal Consolidation? How do the state governments manage their Budgets?

Fiscal Consolidation of the states- It refers to the process of reducing fiscal deficits and public debt by adjusting expenditure and revenue policies. Fiscal Consolidation aims to limit the borrowings by the state governments.

Budgetary Source of State Government

States Demand for Increasing Borrowing Limit (Understanding it through the case of Kerala)

The state government of Kerala’s case study will help us understand the demands of the state governments for increasing the borrowing limit.

State governments argue that the limit on the borrowing by the states is a centrally dictated fiscal consolidation. The state of Kerala has moved to the Supreme Court against this centrally dictated fiscal consolidation of state governments.

What are the challenges faced by state governments in Fiscal Consolidation?

The States are demanding relaxation in the borrowing limit imposed by the centre on account of the following challenges

Expenditure Related Challenges of the State Governments

1. Higher Social Service expenditure by the State Governments- The overwhelming responsibility of social service expenditure (health, education) lies on the shoulders of the State governments.
In 2022-23, the expenditure on social services, by the Union Govt. was ₹2,230 billion while the combined expenditure by all State governments was ₹19,182 billion (8.6 times the Union Govt’s expenditure).

2. Increase in State Government’s Developmental Expenditure- Development expenditure refers to the expenditure on Social services and economic services, such as on agriculture and industry.
The combined developmental expenditures by all State governments has increased from 8.8% in 2004-05 to 12.5% in 2021-22 as proportion of the country’s Gross Domestic Product (GDP). On the other hand, developmental expenditures by the Union government has remained somewhat unchanged over the two-decade period.

3. Capital Expenditure for creation of new jobs and incomes- Higher state government borrowing can generate a virtuous cycle if the borrowed resources are effectively deployed in the capital creation for new incomes and jobs.

4. Alleviation of Livelihood crisis through pensions, salaries and subsidies- The higher expenditure by the State governments that has helped to alleviate the livelihood crisis in the country, caused due to the slow growth of rural incomes and employment. For ex- Large Govt spending on Govt servants (half of them are women) engaged in Social sector in Kerala.

Revenue Related Challenges

1. Reduced Financial Transfers to the States- The share of states in the gross tax revenue (total tax revenue collected, which includes cess and surcharges) has decreased from 35% in 2015-16 to 30% in 2023-24.

2. Erosion of State Taxation Autonomy on account of implementation of GST- The ability of states to set tax rates on their own revenue sources has been significantly diminished due to the implementation of GST. For ex- State VAT have been subsumed under GST

3. Issues with GST- The compensation of revenue loss to states on account of GST implementation, have not been properly addressed. For ex- Discontinuation of GST compensation cess

4. Decrease in Grants-in-Aid to the states- Direct financial support to states, in the form of grants-in-aid, has declined from ₹1.95 lakh crore in 2015-16 to ₹1.65 lakh crore in 2023-24

Other Challenges

1. Violation of the principle of Federalism- States argue that by curtailing their borrowing powers, the Centre is undermining the State’s ability to fulfil some of its basic financial commitments and violating the principle of federalism.

2. COVID-19 Pandemic- The COVID-19 pandemic increased the revenue expenditure and suppressed the revenue receipts, forcing the state Govt to increase their borrowings.

What are the advantages of achieving Fiscal Consolidation of state governments?

1. Improvement of fiscal health of states- Fiscal Consolidation of state governments improves the fiscal health and sustainability of State finances and reduces their debt burden.

2. Enhancement of expenditure quality- Fiscal consolidation enhances the quality of expenditure of state governments and increases the share of capital expenditure in total expenditure. For ex- In FY 2022-23, only 10.6% of Kerala’s budgetary resources was directed to capital expenditure, which is needed to build new infrastructure and institutions to speed up future growth.

3. Fostering economic growth and development- Fiscal prudence gives a boost to public investment in infrastructure and human capital, which fosters economic growth and development.

4. Strengthening of investors confidence- It strengthens the credibility and confidence of investors and creditors in State finances.

5. Fulfilment of FRBM mandate- The States have enacted their own respective Financial Responsibility Legislation in line with the FRBM targets, which caps the annual budget deficits to 3% of Gross State Domestic Product (GSDP). Fiscal consolidation in line with the FRBM mandate will ensure macroeconomic stability and coordination with the Union Government.

What should be the way Forward?

1. Cooperative Fiscal Federalism between state and Centre- The Union government and the State governments must work in close collaboration to review the borrowing targets on account of the state governments increasing developmental expenditures.

2. Increase in the share of capital expenditure- Any increase in the borrowing limits of the state must be tied to capital expenditure. A percentage of increased borrowing must be devoted to capital creation.

3. Reduction of non-productive expenditures- There must be a reduction of expenditure on non-productive items such as excessive subsidies, administrative cost etc.

4. Channelisation of private savings- The state governments can be allowed to access the large reserves of private savings through domestic financial institutions (public sector banks and insurance companies). These savings can then be channelled for productive purposes.

5. Addressing the GST related Concerns- The anomalies in GST like the Integrated GST which favours the consuming states like UP and Bihar, rather than the producing states of TN, Gujarat must be corrected. Also, efforts must be undertaken to open more avenues for revenue generation by broadening the scope of GST to include petrol, diesel.

6.  Revisiting Article 246 and the Seventh Schedule- The taxation powers listed in the seventh schedule must be relooked in the context of fiscal federalism. Rationalisation of Central Sector and Centrally sponsored schemes must be undertaken.